I shared the following note with subscribers on how the current trends in solar/wind power and battery technology are likely to cause disruption in the energy markets. The impact of this disruption is already being felt in the capital goods sector, which is an early proxy of the long term trends in an industry. Any management planning to invest with a 20 year horizon will carefully analyze the long trends before committing capital for this duration..

I have kept out the name of the company we hold, for obvious reasons, but the conclusions are valid for any company in the energy sector value chain. In addition, I think these technologies are likely to have a huge impact in the transportation, oil & gas, coal, power storage and other industries too

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I highlighted the following risk in 2016 for our holding.

Solar energy – I wrote extensively about it in the previous year’s update and the solar energy market continues to develop as expected. It is critical to track this sector as solar is a substitute for other forms of energy (such as coal or Oil) and hence its adoption will have some impact on the demand for the products of the company.

The company continues to focus on process co-gen, waste to energy (including biomass based power generation) and the IPP sector. As I wrote in the previous update, the first two sectors continue to do well as they serve as a complementary power generation system. The IPP segment however is under threat as solar can easily displace this at a lower cost and the company’s performance seems to bear this out.

I have been tracking the renewable and battery/ storage space for the last few years. Let me share some data points before discussing the implications

The graph below shows the price trends for the next 5 years. Please keep in mind that the drops in the recent years have been much higher than predicted and there is no reason why the current rate of 15% annual price drop will not continue

This is a comparative cost across countries

As you can see, India has the lowest costs due to lower soft costs (aka labor costs).

The recent solar auctions in India and several parts of the world are now hitting the 1.3-1.5 Re/KWH levels already and this is expected to drop further. In comparison, the cheapest fossil fuel generated power – Coal, is priced at around 3 Rs/KWH and rising due to transport and other costs

At this point, a lot of naysayers, point out the lack of storage and intermittency of solar and wind power. Let’s look at another data point – Cost of lithium ion storage. This has now hit 200 dollars/ Kwh and continues to drop by around 15% per annum. At the current rate, the cost ofs batteries will drop below 100$/ KWH in 3 years. Why is 100$/KWH important?

This is the point at which solar + Large scale storage start becoming cost competitive with base load or Coal based power. Again, keep in mind that these trends will not stop in 2020, but will keep continuing beyond that due to economies of scale and new research (in other forms of batteries such flow batteries, Lithium air etc)

Is this all hypothetical?
We may assume that all this is theory and the energy markets are yet to be disrupted. That is not true and we already have a few early signs of disruption

a. Gas based Peaker plants (which take care of sudden spike in demand for electricity) are not being built as it is cheaper to use battery storage to take care of such spikes

b. Companies like GE and Siemens have seen a large drop in demand for gas turbines and announced  re-structuring of their power business.

c. What natural gas did to coal, will be repeated again

In 2012-14, we had a new technology called fracking reach scale in the US. This technology had been in development for almost a decade and hit an inflection point in 2014. The resulting glut in natural gas led to a sharp drop in the price as can be seen in the chart below.

The result of this drop was that, natural gas suddenly became cheaper (and cleaner) than coal and caused a switch in fuel for power generation. This can be seen in the picture below. This in turn led to a drop in the demand and price of coal, leading to large scale bankruptcies in the coal sector in the US

Keep in mind that fracking only works if you already have deposits of gas/ oil in place, but were uneconomical earlier. There is no such limitation for solar or wind energy.

Please ignore the S curve
Lets go back to the first principles in economics – People respond to incentives. Companies, individuals and governments are not going to switch to solar or wind energy because they have suddenly realized that these are green technologies, but the because these technologies are now becoming cheaper than the alternatives (fossil fuel).

We still have a lot of naysayers including some of the think tanks, who keep suggesting that these disruptions are atleast 15-20 years away. If you look at the numbers, for some reason their predictions assume that the price drop in these technologies will change from the current 15%+ to around 3-5% due to which the uptake of these technologies will proceed in a linear fashion.

You can believe these predictions if you are ready to ignore the S-curve model of adoption, which states that these kind of non-linear technologies follow an exponential adoption rate till they hit saturation. 

Look at the example of cell phones, internet, Computers and so on which show the adoption rates are only speeding up, not slowing down !

We cannot predict precisely when the inflection will occur. However, it is not difficult to see the disruption ahead. At the current valuations, the market is not discounting the threat of disruption for companies in the capital goods sector, oil & Gas, automotive, power and coal sector.

We can wait till the threat becomes obvious and then exit our positions. I am however not inclined to wait till the last minute before jumping off the track, even though I can dimly see the train coming towards us.    

Investors hear a constant refrain – be patient, think long term, blah blah blah. Is it similar to the sermons we hear about eating well and exercising more?

Let’s walk through a series of logical arguments

1.     The stock market is usually efficient and generally prices most companies correctly based on their near term prospects. So if a company is growing at 30% per annum, earning 25% return on capital and has great long term growth prospects, then the market will value it accordingly.

2.     One can do better than the market only if you have a view about the performance of a company, which differs materially on the upside. If the company performs as the market expects, there will be no impact to the stock price. Only if the company performs better than market expectations, will the stock price will adjust upwards in response to the positive surprise. This is something most investor miss. They are looking for high quality companies with good management. The trick is find those where the market has yet to recognize the quality or improvement in performance (and price it into the stock)

3.     If you combine point 1 and point 2, it follows that some of the ways to do better than the market is if

• You are able to identify the turning point in a cyclical industry, before the market. As it not usually not possible to time this perfectly, the best option is to be a bit early when there are some green shoots visible and then increase the position as the recovery gathers strength
• The profits of the company are suppressed due to some short term issues in the industry (weather, demonetization etc.) which will be resolved soon. In such cases, one has to create a position when the outlook is still horrible and hold on to it till the external factors change for the better
• Some One-off event such as a demerger causes one of the constituents to be mispriced
• The profit of the company is suppressed as management is investing in the business which is hurting the reported numbers. As the market is still fixated on the reported numbers, one can create a position at an attractive price. However one has to wait for the investment phase to complete and the true profitability surface

If you look at all the above cases, one needs to ignore the near term prospects which are being overly discounted by the market, and focus on the long term. As a result, in such cases you will not see a validation of your thesis as soon as you create a position.

For those of us who started investing in the late 90s and even around mid-2000, the level of competition in the market was much lower. One could find companies earning 30% return on capital, growing at 15%+ CAGR and selling at 5 times earnings (Marico was one such company). All one had to do was to dig around a bit and put in the money.

This has changed completely in the last 10 years. We now have an army of smart investors (professional and part-time) who scour the market looking for opportunities. In such as climate, I can bet that you will not find any obvious mispricing which can filtered on a screen.

It would be foolish to assume that the change of opinion will happen as soon as you are done with your purchase. Some of the near term factors which drive the pricing, need to change before the market accepts your view point.

Patience is of course tied with your style of investing and time horizon. If you are a day trader or momentum investor, then time is not on your side. If you time horizon is days, weeks or month then thinking of a multi-year period makes no sense.

I had earlier written above three kinds of edge in stock market investing. The information edge is now more or less gone with tools for quantitative analysis and wide dissemination of information by management (look at the number of conference calls hosted by companies!). One has to rely on analytical and behavioral edge to make above average returns.

Being patient is therefore not a moral imperative or something you need to do for the good of humanity, but is a logical necessity to do well in the market in the long run as a value investor.
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Stocks discussed in this post are for educational purpose only and not recommendations to buy or sell. Please contact a certified investment adviser for your investment decisions. Please read disclaimer towards the end of blog.